Defense Cuts of $500 Billion Vex Officials as Ax Nears

By Laura Litvan -
Jul 2, 2012

Overseeing a series of mandated U.S.
budget cuts in the 1980s and 1990s, former White House official
Barry Anderson was none too popular with agency officials as he
insisted that the reductions be applied uniformly.

Anderson recalls a minuscule 0.0013 cut to all domestic
programs in 1991 that had him directing Coast Guard officials to
nick the budget for maintenance of a single buoy located in the
Chesapeake Bay. It was required by law, he said.

“I used the Chubby Checker ‘Limbo Rock’ test: How low can
you go?” Anderson, who was assistant director of the White
House Office of Management and Budget from 1980 to 1998, said of
the directive that cuts be made to every project. He said he
administered three sets of reductions this way during his
tenure, when a balanced-budget law applied.

With $500 billion in cuts to U.S. defense programs over 10
years set to begin on Jan. 2, industry contractors and analysts
say the challenge isn’t only the amount of the cuts, it’s how
they’ll be managed. They are waiting to hear if the approach in
Anderson’s era will apply -- the White House hasn’t said whether
it’ll give the Pentagon the authority to make choices within
broad categories of spending, or whether it’ll require rigid
program-by-program cuts.

That lack of information is creating uncertainty for
weapons makers and services contractors, who must proceed as
though they won’t have flexibility in applying the cuts.

The defense cuts are part of $1.2 trillion in automatic,
across-the-board cuts to domestic and national-security programs
that will start in 2013 if Congress doesn’t act. The cuts were
imposed after talks failed last year on a bipartisan plan to
curb the nation’s soaring debt.

Negotiations expected later this year will determine
whether the defense cuts can be reduced or averted. Many
Republicans want to renegotiate them by the end of December to
pare back the effect on defense programs, which amounts to
almost a 10 percent cut to the Pentagon’s budget. Democratic
leaders, including Senate Majority Leader Harry Reid and House
Minority Whip Steny Hoyer, say Republicans must be willing to
accept some tax increases in a debt-reduction deal to gain their
support for smaller defense cuts.

Defense Contractors

The effects on defense contractors won’t be immediate. The
process, known as sequestration, affects budget authority or how
much Congress approves for various programs. Companies are
affected by outlays, or government expenditures that take place
when the Treasury Department sends out checks. Outlays change
more slowly, said Todd Harrison, an analyst at the Center for
Strategic and Budgetary Assessment in Washington.

“For the defense industry, it won’t be as sharp a downturn
as it might appear at first because there’s a natural lag,”
Harrison said. “If you’ve got something on contract, it’s not
going to be a sudden shock. It will be a bit more gradual.”

As the maneuvering begins, the White House said it has no
immediate plans to issue guidance on how the cuts will be
implemented. Kenneth Baer, a spokesman for the Office of
Management and Budget, said “we will be prepared” if the
sequester goes forward. Now, he said, the agency is waiting to
gauge whether Congress will reach a debt-reduction deal that
sidesteps the deep cuts.

“While OMB has not yet engaged agencies in planning, our
staff is conducting the analysis necessary to move forward if
necessary,” Baer said.

‘Bad Policy’

Joe Jordan, the White House’s highest-ranking procurement
official, said June 27 that the cuts are “bad policy” intended
to force a budget compromise, and that his office isn’t
preparing for the reductions to take effect.

Jordan, administrator of the Office of Federal Procurement
Policy, said in an interview that the office was “not yet at
the point where we’re planning for that.”

The lack of guidance from the administration is leading to
some tensions with Congress. House Armed Services Chairman
Howard P. “Buck” McKeon, a California Republican, on June 27
told the White House budget director to testify July 18 on how
the defense cuts will be implemented.

Whether both parties can agree on a pact that reduces or
delays the Pentagon cuts isn’t clear, especially as attempts at
deals failed in 2011, said Michael Lewis, a defense analyst at
Lazard Capital Markets in New York.

“Investors should look at this sequestration as a real
threat,” Lewis said. “I have limited confidence that anything
will get done.”

Job Losses

If the sequester goes into effect, it would come on top of
$487 billion in defense cuts proposed by the Obama
administration. The aerospace industry estimates that the budget
cuts would lead to the loss of 1 million jobs. Wage and salary
reductions would reach $59.4 billion, according to a study for
the aerospace trade group by Stephen Fuller, director of the
Center for Regional Analysis at George Mason University in
Fairfax, Virginia.

The top three states for such job cuts would be California,
Virginia and Texas, Fuller’s study found.

Most Risk

A Bloomberg Government study this month found that
Virginia, Hawaii and Alaska would have the most risk to their
economies from the planned cuts. Virginia, home to the Pentagon
and the Norfolk naval base, is at the top of the list as almost
14 percent of its gross domestic product stems from defense
spending, the report found.

The magnitude of the cuts also has yet to be determined.
The first installment, almost $55 billion in 2013, amounts to
about 10 percent of the Obama administration’s base defense
budget request for the fiscal year that starts Oct. 1. President
Barack Obama has the ability to exempt military pay and
benefits, which totals about $135 billion, Harrison said. If he
does so, a 13.5 percent reduction would apply to the rest of the
defense budget, he said.

The Pentagon has made efforts to blunt the effects on
defense programs. The Defense Department said the sequester
process would apply to war funds and unobligated funds in
defense accounts, broadening the pool of money subjected to the
cuts. That means the final reduction would be 9.5 percent across
affected programs, Harrison said.

Sudden Cuts

Contractors worry about a lack of leeway if the full $55
billion in cuts goes into effect. Last year’s Budget Control
Act, which established the sequestration process, said cuts
should be made at the “programs, projects and activities”
level.

“It’s not the depth of the cuts that’s the problem,
Harrison said. “It’s the abruptness of the cuts and the lack of
flexibility.”

Not all companies will be affected in the same way. If the
budget ax falls, contractors that provide services to the
Pentagon, such as Virginia-based Computer Sciences Corp. (CSC) in
Falls Church or SAIC Inc. (SAI) of McLean, probably will see a drop in
revenue faster than weapons makers such as Lockheed Martin,
analysts said.

Services contractors are paid out of “operations and
maintenance” accounts that spend at a faster rate, Thompson
said, and they could experience 50 percent of the effects of
cuts to their Pentagon revenues in the first year they’re
administered, he said. For weapons makers, 25 percent is more
probable, he said.

The stock price of defense contractors could tumble if
progress isn’t made on a deal to avert the sequester, Lewis
said. He expects investors will later go on a value-buying binge
that will help lift share prices.

“I think we will see significant, multiple contractions,
probably in excess of 10 to 20 percent of the current market
prices of these shares,” Lewis said of the anticipated wave of
selling.